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WEEKEND LADDER

A summary of the week’s results

11.05.2018

Week Ending 11.05.2018

Eco Blog

- Post-analysis of the budget points to little short term impact, but does highlight some of the structural issues that face setting policy in Australia.

- China’s financial system will once again be in the spotlight as the A shares (listed in China) move close to inclusion in the major MSCI Indices.  This parallels the regulatory changes that are going some way to limit financial risks.

The Federal Budget has done relatively little for the economic outlook. Nominated infrastructure projects may increase the likelihood that they will come to fruition, but in reality the proposed $75bn investment is the same as last year. Further, it assumes that for projects such as the Melbourne airport link, the state government will pitch in, yet no funding has been set aside in the Victorian budget. Nonetheless, there is a decent amount of work underway in most states and should underpin the construction sector over the medium term.

The adjustment to personal income tax rates are progressive and it will be 2020 before they have a meaningful impact on the household sector. Given the recent fall in the savings ratio and high household debt, it will take wage growth to support a return to the days of higher consumption spending.

In judging the budget, the focus was on spending limits and equity. The apparently precise limit of 23.9% tax as a proportion of GDP appears to be largely based on history. Yet, even with the proposed tax cuts it would reach its upper limit in 2021. That will also be challenged by built-in increases in areas such as health and aged care.

Taxation Revenue (% of GDP)

Source: CBA
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Middle income tax cuts make the most economic sense, given their propensity to spend and plough the money back into the economy. Yet, both lower and upper end households have seen their position deteriorate. For example, the net income that the unemployed accrue is one of the lowest in the OECD as a proportion of net income from working. Conversely, the top marginal rate comes in at one of the lowest thresholds.

As had been the refrain for some time, Australia’s headline corporate tax is high compared to others, but that partly ignores other taxes imposed such as social security tax (Australia is low even allowing for payroll tax), property (Australia above average) and GST (Australia below average). It also brings up the debate on dividend franking. Unlike elsewhere, Australian corporations are incentivised to pay out a large proportion of their earnings rather than reinvest the proceeds. Ironically, it is foreign companies that may benefit most from a corporate tax cut, though that is limited by resource taxes and the low level of payments from the likes of Google or Facebook.

Pensioners are another group that does relatively poorly in Australia. The proportion of those over 66 which have an income lower than 50% of the median household disposable income is the highest in the OECD at just under 30%.

Percentage of population with incomes less than 50% of median household disposable income, 2015

Source: OECD
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Economic growth relies on the 3 P’s – population, participation (in the workforce) and productivity. The participation rate has levelled off after a period of decline as men close to, but not at retirement, leave the workforce. Female participation has conversely increased, led by job creation in healthcare, education and recreational services. Nonetheless, Australia does poorly in encouraging a second low income wage earner within a family. If there are childcare costs and family tax benefits, the average extra cost and loss of benefit takes up over 75% of additional income. The new childcare package will improve the affordability of care but the disincentive from cutting social benefits and potentially repayments on HECS/HELP debt weigh against a cohort from contemplating taking a job.

  • A more optimistic outlook for the Australian household sector is some way away. While this suggests limiting equity exposure to related stocks, there are inevitably a few that can stand out on their own merits.

In the coming week the long-awaited addition of China A shares will be formalised by the index provider MSCI, with 1 June as the implementation date. The partial inclusion based on a 5% weight of approximately 222 stocks will form around 0.75% of the MSCI Emerging Market (EM) Index and 0.1% of the MSCI All Country Index. Assuming full inclusion at some point implies a much heftier potential 18% of the MSCI EM Index, with the overall China exposure including Hong Kong listings at over 40%.

By now many fund managers have taken positions in A share stocks that can also be listed in Hong Kong, though ETFs may yet be buyers. Fund favourites have included Kweichow Moutai (beverages), Hangzhou Hikvision (security systems) and ICBC (finanicals). It is the longer term effect that will matter more. Not least will be the increased level of scrutiny and broker research.

Source: MSCI
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It coincides with new rules that tighten asset management businesses in China to reduce risk. The recent regulation stretched out the implementation date to 2020 to prevent any disorderly transition, but the outcome is clear. The progressive move towards open, liquid and transparent financial markets could take away some of the issues that plague the system to date and add a significant pool of new options for local and international investors.

  • Long term investors should view emerging economy markets as core. Invariably, China is there simply due to its weight, but this should be tempered by the valuation and earnings outlook, as in any market.

Investment Market Comment

- Whilst income-focused ETFs have achieved their yield objectives, total returns have been underwhelming.

Australian equities have provided an important allocation for investors seeking to generate a high-income stream, partly a product of the franking system. As there is a sector concentration for higher yielding stocks, there are heightened security risks. The past 12 months have been challenging for the traditional high dividend stocks. Not only have financials weighed on the market due to the royal commission, sectors such as utilities have seen pressure from higher interest rates.

There are six Australian equity income focused ETFs that each use specific factors or rules in their stock selection. These ETFs are designed to enhance the income, however, the methodologies that these ETFs follow can differ significantly and lead to dissimilar allocations and performance outcomes. 

Relative sector weights to ASX200 indices versus 1-year performance of the index

Source: Morningstar, Escala Partners
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The most common stock selection method is a rules-based methodology which utilizes a combination of factors such as dividend payout ratios, dividend growth, 12-month dividend yield, earnings-per-share and market capitalization to determine the weightings of a portfolio. These rules are designed to generate a higher yield than the market whilst avoiding dividend traps. This is achieved through circumventing companies that have excessive payout ratios or appear to have high yielding characteristics due to a significant price decline. A recent example was Telstra, which cut its dividend last year for the first time in 20 years, and subsequently saw the share price fall by 10%. At the time Telstra’s payout ratio was around 90%. Miners are another example of being screened out as dividends can be variable depending on the performance of commodity prices.

Buy-write strategies are another way investors can enhance their income. This involves buying stocks and writing call options against the position. The premiums received from the writing of the call options provides extra income for an investor, however, it limits potential upside growth and volatility. Therefore, these strategies are expected to underperform in rising markets. BetaShares Australia Top 20 Yield Maximiser offers this strategy, which has been the only dividend focused ETF to offer a (small) positive total return in the last 12 months, though it lags in the longer term. Notably all the ETF strategies lag the total return for the ASX200.

Income-focused ETF performance

Source: Morningstar, Escala Partners
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The worst performer has been the BetaShares Dividend Harvester ETF. This fund adopts a strategy of investing in a concentrated number of stocks that are about to pay a dividend and aims to provide at least double the income yield of the ASX200. To achieve this the fund is rebalanced every 2 months and has a turnover of approximately 600% pa. Whilst the fund has technically met its objective, achieving a yield of 12%, there has been a drought in its capital growth with a total return of negative 15% in the past 12 months.

12-month total return versus 12-month yield

Source: Morningstar, Escala Partners
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  • Higher yielding equity strategies via ETF’s can be at a cost of capital preservation and the differences in approach matter more than the potential for low fees.

Fixed Income Update

- The US 10-year bond trades in a tight trading range as low volatility keeps the yield close to 3%.

- Macquarie Group issues a 6.5-year capital note, while our preference is for hybrids less than 3 years.

- Emerging Market USD debt declines as the strong dollar weighs on prices.

In a very stable period for yields in the US the 10-year Treasury traded just under the 3% mark, at 2.97% having stayed in a tight trading range of 2-3bp for the last two weeks as markets look for direction and await the next round of economic data or central bank commentary.  This week an auction of $25bn of US 10year bonds at a coupon of 2.875% fell notably falling of the 3% milestone. Technical traders suggest that 3.07% is a meaningful level and If yields break through, stop losses in the market will be triggered leading to further price weakening. A failure to rise above this level has others suggesting a retracement back to around 2.75%. The implication is that any move out of this trading range could spur a change in view.

The price volatility in the treasury market (as measured by the MOVE index) has dropped to below 50bp. The last time the index traded at these levels was in the lead up to the spike in yields that took place in early February. Historically, a consolidated period of low volatility will at some point lead to a break out, with yields set to move significantly in one direction or the other.

Volatility in the US treasury market as measured by the MOVE index

Source: Bloomberg, Escala Partners
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This week the Macquarie Group priced a replacement deal of the MQGPA’s hybrid security. The key terms of the new deal are:

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For pricing comparison to existing similar hybrids, we use the first call date which is in 6.5 years. On a relative value basis to where existing issues by the major 4 banks are trading, Macquarie’s own outstanding issues (particularly MQGPB), and the insurers, the new offer (MQGPC) is priced in-line with the current market.

That said, our preference is for shorter dated hybrids, with call dates within 3 years. The reason for this is twofold:

  1. If the Labor party wins the election it has a proposal change the use of franking credits. As the coupon on many hybrids is part cash and franking credit, if this comes to fruition, the hybrid market will inevitably sell off in response. This will have a greater impact on the price of long dated securities, than those that are closer to maturity. While it should be noted that the Macquarie security has only 45% of the coupon franked, compared to the banks at 100%, it will still inevitably be affected by the change.
  2. The other reason is the lack of term premium in the curve. The hybrid curve offers a term premium out to 4 years, with margins generally flattening thereafter. Therefore, investors are getting very little uplift by way of a higher margin beyond 4 years.  
  • This investment may be suitable for those who can tolerate some mark to market volatility, are able to use the franking credits and wish to lock in an income of over 6%p.a. over a longer time frame.

Elsewhere, the USD has strengthened as the rise in crude oil prices, a weaker Euro data and monetary tightening from the Fed has supported the currency. The flow on effect is weakness in emerging market USD denominated debt as the stronger dollar increases the cost of repaying that debt. The iShares JP Morgan USD Emerging Markets ETF is down -6.17% year to date, with half of this decline occurring in the past month.  

  • Investing in emerging market debt has been a popular trade this year. The JP Morgan strategic bond fund and the Legg Mason Brandywine GOFI fund are two recommended strategies that have strategic allocations to this sector (though under 20% of portfolio). Market moves are often indiscriminate, with flows disregarding the differences in balance sheet management and political stability across EM countries. This opens opportunities for investment into countries that are economically sound but have tracked down with others in the sector. However, this tends to be a longer term trade and therefore we allow for that in the recommended investment horizon into these funds.

Price movement of the iShares JP Morgan USD Emerging Markets ETF

Source: Bloomberg, Escala Partners
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Corporate Comments

- Westpac (WBC) half year result was better than its peers in a fairly benign reporting season for the major banks.

- Orica (ORI) is still yet to see the benefits from better commodity markets in its business, with issues that are partially self-inflicted.

- WorleyParsons (WOR) held an investor day, providing further evidence that its earnings cycle is continuing to improve.

Westpac (WBC) this week wound up half yearly reporting season for the banks, with a result that was slightly ahead of consensus expectations. The outcome was considered perhaps the best of the majors, although less impressive considering the soft industry-wide conditions. As illustrated in the table below, profit growth has been relatively limited in the half and, with the exception of Commonwealth Bank, dividends have been held steady.

Major Banks: 1H18 Underlying Results Summary

Source: Company reports, Escala Partners
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The main surprises in WBC’s result was a better outcome on interest margins and a further reduction on its bad debts charge (also a feature of ANZ’s result). Costs were relatively well contained and in line with the bank’s guidance, while its capital levels are in good shape.

The key difference of WBC with the two other majors that have reported in the last week is its steady strategy which does not involve major divestments (such as ANZ) or large structural cost savings targets (e.g. NAB). Consequently, there is likely less risk given the implementation challenges of its peers, although there is also less potential upside.

Those with a negative view on the stock point to its overweight position in domestic mortgage lending and, in particular, investor loans and the associated margin impact as they roll over into principal and interest. Additionally, reports suggest it has weaker lending standards, a point which it has refuted given the solid performance of its portfolio. As with the other banks, the key attraction resides with its dividend yield, although as illustrated by this reporting season,  investors should expect little in the way of dividend growth in the medium term.

Orica (ORI) retraced this week after yet another earnings miss. Despite marginal volume growth in its core ammonium nitrate explosives business, weaker margins led to a 36% decline in underlying net profit. “One-off” significant items, arguably a misleading description given the frequency of occurrence in ORI’s results, totaled $353m (including a further impairment of its Minova business), resulting in a net loss for the half.

From a macroeconomic point of view, the outlook for ORI should have been improving for some time, with its fortunes largely tied to volume growth in the mining industry. However, for various reasons, the mining recovery over the last two years has not translated into better earnings. One issue has been poor operational performance, with unplanned maintenance work increasing its cost base. Higher input costs have also hurt (such as rising gas prices), which have not been recovered through pricing adjustments and margins were weaker in the half.

Orica: Australia, Pacific and Asia Division: AN Volume and Margin

Source: Orica
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A further issue for ORI is that the price flow-through from a better demand environment is particularly slow. Contracts with its customers are typically long term (up to five years in length) and therefore current pricing does not necessarily reflect current conditions; indeed, weaker prices were a headwind for the half. While this may mean a delayed improvement in coming periods, the well-supplied nature of several of its key markets may mean that this impact will be overestimated in coming periods. In light of these issues, ORI’s share price has struggled in the last 12 months. We note, however, that it has re-rated off its low point of two years ago, which may be difficult to justify given its issues.

A company that has more leverage to the resources recovery is WorleyParsons (WOR), which hosted an investor day this week. WOR is dependent upon capital expenditure among its oil and mining customer base and the outlook is relatively positive. Oil and gas is WOR’s principal exposure and there are several justifications for improving earnings in the medium term.

Firstly, is the forecast recovery in spending among oil and gas majors (8% growth in 2018), which has followed several years of underinvestment. This is largely an outcome of a price downturn few has anticipated, and a combination of balance sheet pressure across the industry and short-term cash flow maximisation such that even ‘sustaining’ capex levels were sharply reduced. While the market is not expected to return to near the high capex years when oil was greater than US$100/barrel, profitability has still improved markedly in the last year and some of this excess capital will invariably find its way into investment.

Secondly, the natural field decline in oil (estimated at 5-7%) leads to higher levels of required exploration investment on an ongoing basis and a degree of catch up is required. On the assumption that OPEC holds its line with its production cuts, the recent rise in the oil price points to a tightening market that will require additional supply and hence spend by the oil majors. A lack of investment has also emerged in LNG, which is well supplied in the short to medium term. The long lead times on these projects, however, will mean that further investment will likely be started some years ahead of better market conditions.

Lastly, WOR has taken considerable overhead costs out of its own business through the downturn, leaving it well placed to record margin growth as the cycle improves. Staff utilisation rates have again risen to the company’s 85% target rate, an indication that it has adjusted its employee numbers. With a rising backlog of work, a balance sheet that is now in better shape (allowing the company to reintroduce a dividend) and a recovering cycle that is relatively immature in nature (and with likely earnings upside to consensus given the oil price rally through this year), we recently added WOR to our model portfolio.

WorleyParsons: Staff Utilisation

Source: WorleyParsons
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